Steering Clear Of Bubble Trouble

In a relentlessly inscrutable housing market, there are ways to minimize risk

Lots of people think they see bubbles in real estate, but few react as strongly as Michael Stambaugh, an investment officer for a private endowment. Last summer he and his wife, Dana, sold their small one-bedroom Manhattan apartment for $380,000 and moved into a rental unit, figuring they would stash their real estate windfall in a money-market mutual fund, then buy again when prices fell and they could get a bigger place. Unfortunately for them, Manhattan prices, already sky-high, have risen 30% in the year since they sold. Now the Stambaughs couldn't even afford to buy back their old 650-square-foot apartment. Waiting for the bubble to pop is getting old fast. "I'm not here to lobby for a destruction of wealth," says Stambaugh. "But it's kind of frustrating -- actually, very frustrating."

This is the U.S. real estate market today: Cautious sellers are left behind; devil-may-care buyers appear to be geniuses. When prices keep going up, it's easy to laugh at the Jeremiahs who began warning years ago that the end was near. The national debate has even taken on moralistic tones -- dour bears vs. sunny bulls. "Something is going to happen, it's just a matter of when," growled one bear recently on BusinessWeek Online's Hot Property blog. At backyard barbecues and in office cubicles, housing is all anyone can talk about: How much longer can this go on? And what's the smartest way to play this crazy market?

The good news: Even if house prices do tumble, most people should come out O.K. -- if they're prepared to sit tight for a few years until the market recovers. If you worry that prices could fall, try to arrange things so you won't be forced to move and sell at a loss when the market's down. Refinance into a conservative mortgage. Consider selling a second home or rental property. If you're retired, think about a reverse mortgage that lets you borrow against your new housing wealth.

Naturally, everyone wants to ride the housing market to the very top, but it's impossible to get a clear read on where that top is. On the bullish side, price gains from Miami to San Diego show no signs of overall slackening. The National Association of Realtors says the national median sales price for existing homes rose 14.7% in the year through June -- the biggest gain since 1980. On the bearish side, though, there are hints of softness in sizzling markets such as Las Vegas, Boston, and elsewhere. In Los Angeles, homes that stay on the market for a few weeks are starting to sell below asking prices. In Orlando and West Palm Beach, prices are way up, but sales volumes are down around 15% from a year ago.


Still, that's hardly proof positive that the market has peaked. "Almost by definition, you don't know how big [bubbles] are going to get because you've departed from fundamentals," says John P. Calverley, the London-based chief economist of New York-based American Express Bank Ltd. (AMX ), and author of the recent book Bubbles and How to Survive Them.

In the absence of solid information, the most sound advice is to hope for the best and prepare for the worst. Simply put: "Don't buy property that you can't afford," says David Stiff, chief economist of Fiserv CSW Inc. of Cambridge, Mass., which forecasts house prices.

What do you do if you really think the market is heading down? The most bearish option is to do what the Stambaughs did -- sell and rent, planning to buy again after prices have fallen. But that could leave you dangerously exposed if you're wrong. Moreover, transaction costs of buying and selling homes are so high that they tend to swallow any gains from jumping in and out of the market, especially since house prices -- when they decline at all -- usually go down less than high-flying stocks.

Other financial strategies are risky as well. Some analysts argue that you should short-sell the stocks of lenders and builders; in a housing slump, they believe, the profit earned on your short positions would offset any losses on your house. But it's expensive to short stocks for a long time, and there's always a risk that they won't ever fall. Beyond that, people have been trying for years to create securities that allow owners to hedge against declines in their local markets. But no housing derivatives have attracted enough trading to make them a go.

If you need to buy because you're moving or your family has grown, settle for a place you can pay for without resorting to a zero-down, interest-only mortgage. Many people are buying houses they can't afford using mortgages with low initial payments, figuring they'll sell or refinance when higher payments kick in. But if rates rise and real estate slumps, those escape routes will be cut off. If you already own and were thinking of moving to a smaller house or a cheaper city in the next few years, think about doing it now to lock in your gains. Also, consider selling rental properties or vacation homes that have appreciated a lot. A reverse mortgage is good for people in their sixties or older who are house-rich and cash-poor. You can borrow against the equity in your house and never repay the loan as long as you live in it.

In today's boom market, such precautions seem excessive. But they're mild compared with dumping real estate completely. Says Richard Laermer, another Manhattanite who sold his apartment and is biding his time till the market falls: "I'm in total sour-grapes mode right now." The only question is how long he'll stay that way.

By Peter Coy in New York, with Rich Miller in Washington, Dean Foust in Atlanta, and Christopher Palmeri in Los Angeles

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